September 2007


Just like the world’s top footballers these days, loyalty is a forgotten word in the investment industry, as finance hotshots go to where the best bonuses are or, increasingly, start their own hedge funds. By Iain Morse

07_09_star_player.jpg“These days, post Big Bang, a job in the City requires 100% commitment but 0% loyalty,” judges Philip Augar, author of The Death of Gentlemanly Capitalism.  In this brave new world brokers and  traders hot desk to the highest bidder in return for hefty bonuses. Big Bang ruptured the settled patterns of ownership in London that had endured for several centuries, thereby transforming the business of recruiting and retaining staff. This set off a wave of change and restructuring that has swept through mainland Europe’s financial services industry. In some countries, like Holland, the extent of change has equalled that in Britain. Elsewhere, in countries such as Germany and Italy, it has been more uneven. But one thing is clear, a bonus-based culture now rules all corners of the financial services and asset management industry. This is as true of the back and mid office as the front.


The rise of quantitative trading
Bonus culture is all about alignment and motivation; that of individual and team with employer and employer with client. The advent of screen-based trading and the deregulation of markets opened the way to a huge increase in the volumes of shares and bonds traded and a broadening of the  range of instruments to include futures and derivatives. “Training back and mid office staff to understand what these are is now a necessity,” says Albert Gnand, executive director and head of business support at UBS Fund Services. “It is no longer possible for only front office fund managers to have this competence.” The complexity of instruments traded is constantly increasing. Take London as an example. In 1986, the annual turnover in domestic equities on the LSE was £161bn (e238bn), now it is £2,495bn (e3,687bn). Then, there were no foreign equities traded on the LSE, now the annual value of turnover is £2,703bn (e3,995bn). The growth in foreign exchange daily turnover has been even more astronomic, from $50bn (e36.7bn) a day then to $1,210bn (e888bn) today. Derivative contracts have also increased exponentially from 17 million per month to over one billion per month today. UK banking assets have increased from £762bn (e1,126bn) to £5,526bn (e8,169bn).

As screen-based trading took over exchanges in the late 1980s it became clear that personal relationships would henceforth be sidelined and might even be an impediment to optimal trading. What mattered was first understanding and then making a turn from moving averages and standard deviations, buying and selling on margin against sometimes tiny movements in the relevant market. The advent of screens and then of cheap and powerful computing capacity marked the rise of quantitative trading strategies. Notions of personal trust and loyalty were superseded by those of corporate compliance.

Family ownership and partnership used to be the dominant models for management in the City of London and the rest of Europe. The exception to this were large insurance companies and the so-called bancassurers, which both manufacture and distribute wide ranges of product. Many of the large insurance companies were mutual rather than proprietary with cosy, dull-edged corporate cultures. These are long gone. Meanwhile,  the collapse or sale of many merchant and private banks in the 1990s and the need to aggregate broking have completely undermined the old models of management. Few private limited liability companies survive and none are of any importance; the US-based Fidelity is now the only global, family owned fund management company. In London, even Cazenove, which hung on longer than any of its rivals, has had to reach an accommodation with JPMorgan. The structure of the main institutions are now listed and heavily regulated, particularly in areas such as meeting regulatory requirements on capital adequacy.  Whereas under the old system only partners would take a share of profits, nowadays staff expect basic  salary, cash bonuses and shares.

Educational requirements
These changing patterns of both trading and ownership have precipitated a huge change in attitudes to the minimum educational requirements to work in the industry. In the pre-Big Bang world, training was on the job and often informal. As a rule of thumb, minimum conditions of entry to the front office are now the possession of a degree and one or more

post graduate or professional qualifications from a fairly small number of organisations; these include the Institute of Chartered Accountants, Institute of Certified Chartered Accountants, and pre-eminently in the USA and the UK, the Chartered Financial Analysts (CFA) Institute. There are other qualifications, such as those from the Association of Certified International Investment Analysts backed by some of the bodies representing European professionals. Numeracy is a prerequisite for passing the CFA; a grasp of basic differential calculus is a necessary condition for understanding the valuation models used in pricing derivative and forward contracts. What all these qualifications serve to codify are the consequences of moving to screen-based trading. But not all is lost for those without this kind of intellectual skill; the burgeoning  private equity industry may require basic accountancy skills but is still a ‘people business’.

The mid and back offices have also undergone a revolution in attitudes on training and competence. There is a scarcity of public examinations or courses for vital mid to back office functions so employers have to build their own in-house training programmes. Take UBS Global Asset Management Services as an example of best practice. As of 31 March this year, UBS-GAMS administered funds worth e379bn, a hefty sum. “One of the main challenges we face is keeping pace with the rapid evolution taking place in the asset management industy,” judges Gnand. The UBS-GAMS approach is to educate as widely as possible, using in-house training and testing which is linked to career progress in the organisation. Its award-winning training courses are ambitious in scope. For example, these include the Advanced Instruments Course (2007), which includes modules on credit (riks and spread, CDOs, CDSs), classic option strategies (benefit option strategies, optimisation, capital protection) equity swaps (synthetic equity exposure, swaps, total return vs price , the use of swaps) and value-at-risk (key risk measures, what is VAR, and VAR and fund management). “This all about making sure that we can offer clients a state of the art service,” adds Gnand.

The business of bonuses
Meanwhile, the size of the pot available to pay bonuses directly reflects the business position of a company. Policy on bonus distribution among staff varies from employer to employer and is often a closely guarded secret, but tends to foster team structures. In the case of the investment banks bonuses will be paid to all team members from leaders to dedicated secretarial support. Critics of this system argue that it can be indiscriminate; its advocates that it fosters a strong focus on revenue generation. The real issue dividing opinion is whether and how to reward underperformers. Banking is a cyclical business. At a time when merger and acquisition may be generating huge fees and commissions, IPO activity may currently be a more modest source of revenue but the banks will want to retain a capability in this area.

Last year’s frenzy of merger and acquisition activity should be boosting bonuses all round, but there are signs that some banks are changing policy on bonus distribution. “Management is more aware of which bankers own relationships and which merely sit on a strong franchise,” judges Matthew Osborne, senior executive at Armstrong International, the executive search firm that publishes a widely read annual survey of bonuses in the European banking industry. Armstrong’s 2006 survey shows that those working in high-margin growth areas such as structured credit, equity derivatives, commodities, private banking and corporate finance saw their bonuses rise 10-30% on the previous year.

But the bonuses for second and third quartile performers were no larger and some even smaller than in 2005. Individual, ‘star’ performers, including successful team leaders, will have enjoyed bonus increases of up to 30%. Armstrong estimates that top traders in of structured credit products received $2m (e1.46m) to $3m (e2.2m), while global heads of credit earned more than $4.5m (e3.3m). The compensation mix of cash and stocks is much the same as in earlier years. For instance, vice presidents in a US bank would expect to receive 25% to 30% of their total remuneration in company stock, while managing directors  receive up to 40% of remuneration in stock. Investment banks use complex and opaque methods to calculate bonuses and there are significant variations between these formulae. Most put around 50% of their net revenues into a pay pool, which is then allocated according to the revenues generated by different divisions, teams and key personnel.

Beyond the bonus culture
It is an irony that after Big Bang, and a relentless process of rationalisation across Europe, the  bonus culture has started to look out of date. Leave the Square Mile, move a little westwards and you find yourself in hedge fund country. Go also to Frankfurt or Paris and hedge fund managers earn more from running their own businesses. Over the last ten years they have catalysed real change among traditional long only managers. The standard formula for charging on hedge funds is  an annual charge on assets under management and a further ‘hurdle rate’, usually ten to 25% of the excess of a benchmark like Libor. The huge majority of hedge fund managers also have equity in their funds, the major source of their wealth. Attempts to halt the defection of talented managers, the long only managers have been forced to graft on elements of hedge fund profit sharing alongside their existing remuneration structures but only with varying success. More and more boutiques manufacture then sell their product to distributors that are gradually withdrawing from fund management. The full effects of this have yet be played out.

© fe September 2007